Carbon risk not accurately measured in portfolios, says Morningstar

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on February 25, 2019 - March 03, 2019.
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Although investors are urging portfolio companies to address climate risk by transitioning away from carbon-heavy industries, these “transition risks” are often not well measured and therefore, not accurately reflected in an investment portfolio, says investment research firm Morningstar.

Transition risks refer to just how vulnerable a company is to the transition from a fossil-fuel-based economy to a lower-carbon one. Specific transition risks include policy and legal regulations limiting carbon emissions, the cost of switching to new technologies and changing consumer preferences.

According to the Morningstar report, Preparing for a Low Carbon Economy: Investing in the Era of Climate Change, while fossil fuel exposure is a major component of carbon risk, nearly half of global market capitalisation, by some estimates, have exposure to carbon risk of some kind. An adequate assessment of carbon risk in an investor’s portfolio will help mitigate traumatic transition impacts later on.

The report, published late last month, notes that most efforts to measure carbon risk in portfolios have thus far relied on a technique called “carbon footprinting”. The portfolio’s carbon footprint is calculated by estimating the GHG emissions that are attributable to each underlying asset.

Scope 1 GHG emissions are said to emanate from a company’s internal operations such as on-site energy production, vehicle fleets, manufacturing operations and waste. Scope 2 emissions are indirect emissions generated by the production of energy used by the company and Scope 3 emissions are indirect emissions that occur in the upstream and downstream value chain.

However, there are a number of limitations to carbon footprinting, not least of which is incomplete or inaccurate emissions data provided by portfolio companies. Also, this technique does not take into account Scope 3 emissions. Further, carbon footprinting does not consider the financial materiality of a company’s carbon-risk exposure or its strategy to manage such risks.

To address these issues, Morningstar has collaborated with Sustainalytics, which rates the sustainability of listed companies based on their environmental, social and corporate governance (ESG) metrics, to provide deeper insights than traditional carbon footprinting alone can provide.

Through the collaboration, Morningstar created its Morningstar Portfolio Carbon Risk Score, a metric that investors are able to use to evaluate carbon risk at the portfolio level. The Carbon Risk Score is calculated across the firm’s managed investment universe, thereby allowing comparisons between investments, categories and benchmarks, as well as longitudinal analysis.

Using the metric, a company’s carbon risk rating is based on assessments across two dimensions: exposure and management. Exposure is a measure of the degree to which carbon risks are material across the company’s supply chain, its own operations and in its products and services. Management is a measure of the ability and approach of the company to manage and reduce emissions and related carbon risks.

The carbon risk rating that Sustainalytics assigns is the remaining unmanaged carbon risk of a company, after taking into account its efforts to mitigate carbon risk through its management activities. The lower a company’s carbon risk score, the lower its unmanaged carbon risk.

A company’s exposure to carbon risk is largely driven by the type of business it is engaged in. Carbon exposure is measured by sub-industry, with company-specific adjustments made as necessary. So far, Sustainalytics divides the universe into 146 global sub-industries. For some of these sub-industries, a large portion of their carbon-risk is built into the industry and cannot be managed away.

As an example, the report points out that the airline industry has significant carbon risk exposure. The assessment is that 60% of the carbon risk exposure is unmanageable because there are no current alternatives to fossil-based jet fuel. The other 40% of carbon risk exposure can be managed through things such as increased routing efficiency or engineering planes for better fuel economy.